Understanding what credit is and how your credit score can be improved is a crucial step toward reaching your financial goals. Your credit score is a measure of factors that may affect your ability to repay credit. It's a complex formula that takes into account how you've repaid previous loans, any outstanding debt, and other financial history.
A credit score is dynamic and changes according to how much debt you accrue and how you manage your bills. To build credit wisely, learn how the Five C's of Credit – character, capital, capacity collateral and capacity — can affect your credit score and how you can use these five factors to strengthen your credit:
1. Character. A lender may decide whether you possess the honesty and reliability to repay debt based on your credit history. Lenders are likely to look at your credit use, bill payment, residential history, and how long you've worked at your current workplace.
The most effective way to strengthen your credit reliability is to make payments on time. Many credit card companies offer free, automatic alerts to help you keep track of your balances, payment due dates, payment history and purchase activity.
2. Capital. A lender will want to know if you have valuable assets such as real estate, personal property, investments or savings with which to repay debt if income is unavailable.
Learn the best ways to save for your goals in order to gain these valuable assets and potentially boost your credit score.
3. Capacity. This refers to your ability to pay off debt. Lenders will look to see if you have been working regularly in an occupation that is likely to provide enough income to support your credit use. They may look at your salary, check whether you have pre-existing loans or debts, and assess whether you have family members who depend on your earnings.
4. Collateral. A lender may require you to put up some form of collateral — a property or asset — for certain types of loans like auto loans. When you take out a car loan the vehicle you buy is typically used as collateral for the loan.
5. Conditions. This refers to the condition of the economy and how it may affect your ability to repay the loan.
To ensure you aren't taking on more than you are capable of paying off, follow the 20-10 Rule. This rule of thumb suggests you avoid borrowing more than 20 percent of your annual net income on all your loans (not including mortgage loans), and that payments on those loans do not exceed 10 percent of your monthly net income.
Use A Secured Credit Card Account
If you're opening your first credit card account or you're trying to rebuild a damaged credit score, a secured credit card account is one of your best options. The main advantage of a secured credit card is that you cannot use it to spend outside your means. You are required to make an initial deposit to open a secured card, and after that you will only be able to spend up to 100 percent of that deposit amount. For example, if you put $500 in the account, you can charge up to $500 on your secured card.
If you consistently make your payments on time, it could be possible to transform your secured card into an unsecured card from a credit card issuer, boosting your credit score. Unsecured cards don't require an initial deposit to open, and it is possible to charge more than you can pay off. For this reason, secured cards are the best option until you're certain you will always spend within your means and pay off your balance on time.